Who will guard the guardians?
Juvenal During the summer of 2006, a syndicate of investors led by The Blackstone Group, one of Wall Street’s largest private equity investment firms, initiated a secret plan to acquire Freescale Semiconductor. Based in Austin, Texas, Freescale was among the world’s largest producers of semiconductors and for decades was a subsidiary of Motorola, Inc., the large electronics company. In July 2004, Motorola spun off Freescale in one of that year’s largest initial public offerings. Blackstone retained Ernst & Young (E&Y) to serve as a consultant for the planned buyout of Freescale. Among other services, Blackstone wanted E&Y to review Freescale’s human resource functions and to make recommendations on how to streamline and strengthen those functions following the acquisition. James Gansman, a partner in E&Y’s Transaction Advisory Services (TAS) division, was responsible for overseeing that facet of the engagement. Similar to the other Big Four accounting firms, E&Y became involved in the invest- ment banking industry during the 1990s. In fact, by the late 1990s, the small fraternity of accounting firms could boast of having two of the largest investment banking practices in the world, at least in terms of the annual number of consulting engagements involv- ing merger and acquisition (M&A) deals. In 1998, for example, KPMG consulted on 430 M&A transactions, exactly one more than the number of such engagements that year for PricewaterhouseCoopers (PwC). Despite those impressive numbers, KPMG and PwC had not established themselves as dominant firms in the investment banking industry. In 1998, the total dollar volume of the M&A engagements on which KPMG and PwC consulted was $1.65 billion and $1.24 billion, respectively. Those numbers paled in comparison to the annual dollar value of M&A transactions for industry giants such as Goldman Sachs, which was involved in M&A deals valued collectively at nearly $400 billion in 1998. At the time, Goldman Sachs, Lehman Brothers, Morgan Stanley, and the other major investment banking firms consulted exclusively on “mega” or multibillion-dollar M&A engagements. By contrast, the “low end” of the M&A market—in which the Big Four firms competed—typically involved transac- tions measured in a few million dollars. E&Y’s involvement in the huge Freescale M&A deal was a major coup for the Big Four firm. When the transaction was consummated in December 2006, the price paid for the company by the investment syndicate led by The Blackstone Group approached $18 billion. That price tag made it the largest private takeover of a tech- nology company to that point in time as well as one of the 10 largest corporate take- overs in U.S. history. Not surprisingly, Blackstone demanded strict confidentiality from E&Y and the other financial services firms that it retained to be involved in the planned acquisi- tion of Freescale. James Gansman, for example, was told that Blackstone wanted the transaction to be “super confidential” and was instructed in an internal E&Y email to “not breathe the name of the target [Freescale] outside of the [engagement] team.

”1 1. U.S. Department of Justice, “Former Ernst & Young Partner and Investment Banker Charged in Insider Trading Scheme,” 29 May 2008 (http://newyork.fbi.gov).

Ethical REsponsibilitiEs of accountants During June and July 2006, while he was working on the Freescale engagement, Gansman passed “inside information about the pending transaction”2 to Donna Murdoch, a close friend who worked in the investment banking industry. An FBI investigation revealed that Gansman and Murdoch “communicated over 400 times via telephone and text messages”3 in the weeks leading up to the September 11, 2006, announcement that the Blackstone investment syndicate intended to acquire Freescale. In that time span, Murdoch purchased hundreds of Freescale stock options, which she cashed in on September 11-12, 2006, realizing a windfall profit of $158,000. The FBI also determined that between May 2006 and December 2007 Gansman provided Murdoch with information regarding six other M&A transactions on which E&Y consulted. In total, Murdoch used that inside information to earn nearly $350,000 in the stock market. Murdoch gave that information to three other individuals, includ- ing her father, who also used it to produce significant stock market profits. Published reports indicate that Murdoch became involved in the insider trading scheme to help make the large monthly payments on a $1.45 million subprime mort- gage on her home. The funds she initially used to “play the market” were provided to her by one of the individuals to whom she disclosed the inside information given to her by James Gansman. In addition, Gansman at one point loaned her $25,000. The Securities and Exchange Commission (SEC) uses sophisticated software pro- grams to detect suspicious trading activity in securities listed on stock exchanges. In early 2007, the SEC placed Murdoch on its “watch list” of individuals potentially involved in insider trading and began scrutinizing her stock market transactions. Information collected by the SEC resulted in criminal charges being filed against Murdoch. In December 2008, she pleaded guilty to 15 counts of securities fraud and two related charges. In May 2009, Murdoch served as one of the prosecution’s principal witnesses against Gansman in a criminal trial held in a New York federal court. During the trial, Gansman testified that he had been unaware that Murdoch was acting on the information he had supplied her. Defense counsel also pointed out that Gansman had not personally profited from any of the inside information that he had been privy to during his tenure with E&Y. Nevertheless, the federal jury convicted Gansman of six counts of securities fraud. A federal judge later sentenced him to a prison term of one year and one day. EPILOGUE Personnel at all levels of the Big Four account- ing firms routinely gain access to highly confi- dential inside information, information that can be used to gain an unfair advantage over other stock market investors. Unfortunately for the accounting profession, James Gansman is not the only partner or employee of one of those firms who has been implicated recently in a major insider trading scandal. In January 2008, the SEC charged two for- mer PwC employees with using confidential client information to earn large profits in the stock market. One of the individuals was on PwC’s audit staff, while the other was assigned to PwC’s Transaction Services group, the PwC division comparable to E&Y’s TAS department.4 The individual in the Transactions Services group accessed the confidential information

1. Ibid. 3. Ibid. 4. A. Rappeport, “Ex-PwC Pals Were Inside Traders, SEC Says,” CFO.com, 15 January 2009.

fREEscalE sEmiconductoR, inc.
347 while working on several M&A consulting engagements for PwC. He then provided that information to his friend on PwC’s audit staff, who used it to purchase securities of compa- nies that were acquisition targets. This latter individual’s name was recognized by a PwC audit partner when he was reviewing a list of securities transactions for a client that another company was attempting to acquire. The audit partner informed the SEC, which then filed insider trading charges against the two friends. In November 2010, the U.S. Department of Justice filed insider trading charges against a former Deloitte tax partner and his wife, who had also been employed by that firm.5 The couple allegedly obtained confidential informa- tion regarding seven Deloitte clients that were involved in M&A transactions. According to the SEC, the couple communicated that infor- mation to family members living in Europe who then engaged in securities trades involv- ing the companies that were parties to those transactions. The SEC reported that more than $20 million in illicit stock market gains were earned as a result of the scheme.6 The case was ultimately resolved with the charges being dropped against the tax partner when his wife admitted that she was solely responsible for passing the inside information to relatives. The partner’s wife obtained the information by eavesdropping on her husband’s telephone conversations. She was subsequently sentenced to 11 months in prison by a federal judge. In the 38 years that he spent with Deloitte, Thomas Flanagan worked his way up the employment hierarchy of the Big Four account- ing firm from staff accountant to vice chairman. In October 2008, Deloitte announced that it was suing Flanagan for trading in the securities of multiple Deloitte audit clients for which he had served as an “advisory”7 partner. Deloitte claims that Flanagan held and traded securities of his own clients for the past three years. The firm alleges he bought one of his client’s stock one week before it announced an acquisition of a public company. He is also accused of violating the firm’s indepen- dence and conflict-of-interest policies and hiding his personal securities holdings from Deloitte. In his role as an advisory partner, he attended the audit committee meetings of seven of the twelve clients affected.8 The Deloitte clients involved in Flanagan’s insider trading scheme included Allstate, Berkshire Hathaway, Best Buy, Sears, and Walgreens. In August 2010, the SEC announced that it had settled the insider trading charges that it had filed against Flanagan. The terms of the settlement required Flanagan to pay more than $1 million in fines and penalties. Flanagan consented to the settlement without admitting or denying the SEC’s allegations. Flanagan’s son, who had allegedly made securities trades based upon inside information given to him by his father, reached a similar settlement with the SEC and paid fines and penalties of approximately $120,000. In October 2012, a fed- eral judge sentenced Thomas Flanagan to 21 months in federal prison after he pleaded guilty to insider trading. During the sentencing hear- ing, Flanagan remarked that his conduct “was stupid, it was arrogant and it was wrong.”9 In addition to the 21-month prison sentence and the SEC fines, Flanagan will reportedly forfeit more than $14 million in pension benefits and

P. Lattman, “Couple Accused of Trading Insider Tips,” New York Times (online), 30 November 2010. 6. E. Stevens, “Pacific Heights Socialites Charged in Elaborate Insider-Trading Scheme,” Bay Citizen (online), 9 January 2011. 7. A Deloitte “advisory” partner is typically a senior audit partner who has significant industry exper- tise relevant to a given client. In addition to consulting with members of an audit engagement team on important issues arising during an audit, an advisory partner typically reviews the audit workpapers before the engagement is completed. 8. S. Johnson, “Deloitte Insider Case Sparked Doubts About Audits,” CFO.com, 10 November 2008. 9. B. Carton, “21-Month Sentence Just One of the Consequences of Former Deloitte Partner’s Insider Trading” www.complianceweek.com, 30 October 2012. Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in wh

Ethical REsponsibilitiEs of accountants deferred compensation as a result of settling the civil lawsuit filed against him by Deloitte. To date, the most publicized case of insider trading by an independent auditor involved Scott London, a longtime and high-profile audit partner with KPMG. In addition to supervising the audit practice of KPMG’s large Los Angeles office, London served on Los Angeles’ Chamber of Commerce and chaired the Los Angeles Sports Council. In June 2013, London pleaded guilty to insider trading, “admitting he revealed secret information about his company’s clients to a friend who used the tips to make more than $1 million from resulting trades.”10 In exchange for the stock tips, which took place over several years, London received gifts and cash payments from his friend. In a statement issued through his attorney, London indicated that “What I have done was wrong and against everything that I had believed in. I spent nearly 30 years at KPMG Questions and I dedicated my entire life to that firm.” During an appearance on CNBC, London’s attorney reported that his client had realized that he was violating federal laws when he pro- vided the inside information to his friend. “But he just can’t understand why he did it, and it’s hard to understand why he did it. It makes no sense. . . . It made no sense from a dollar- and-cents point of view; it made no sense in terms of his ethics.”11 The attorney added that London’s personal and professional lives had been ruined by the scandal. “He’s 50 years old, he’s lost his career, he’ll probably lose his license, he’s been disgraced. . . . It’s a very grim reminder of the consequences for anyone who wants to leak insider information.”12 In April 2014, a federal judge sentenced London to serve 14 months in federal prison. Prior to his sentencing, London agreed to sur- render his CPA license in a negotiated settle- ment with the California Board of Accountancy.

1. Identify the specific circumstances under which auditors are allowed to provide confidential client information to third parties. 2. Suppose that you and a close friend are employed by the same accounting firm. You are assigned to the firm’s audit staff, while your friend is a consultant who works on M&A engagements. What would you do under the following circumstances: (1) your friend discloses to you highly confidential “market- moving” information regarding a soon-to-be announced merger;

(2) your friend not only discloses such information to you but also informs you that he or she plans to use it to make a “quick” profit in the stock market? In your responses, comment on your ethical responsibilities in each scenario.

1. E&Y was providing a consulting service to The Blackstone Group in connection with its planned acquisition of Freescale Semiconductor. Explain how a CPA’s professional responsibilities differ between consulting engagements and audit engagements.
2. S. Pfeifer, “Former KPMG Partner Scott London Pleads Guilty to Insider Trading,” Los Angeles Times (online), 1 July 2013. 11. P. Lattman, “Ex-KPMG Partner Is Charged in Insider Case,” New York Times (online), 11 April 2013. 12. Ibid. Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200